Tax Loopholes, Wealth Destruction, and Health Reform

AT&T (T), Caterpillar (CAT), Deere (DE), and Verizon (VZ) garnered headlines last week (and an unwelcome summons to Capitol Hill) for announcing that a provision in the recent health care legislation would result in substantial accounting write downs. AT&T, for example, told the SEC that it expects to take a $1 billion charge in the first quarter because the law eliminates a tax subsidy for providing prescription drug coverage to retirees. According to the Wall Street Journal, Credit Suisse estimates that the total accounting hit for corporate America will total $4.5 billion.

To figure that out, I spent a lovely Saturday afternoon tracking through the intersection of health policy, tax policy, and financial accounting and emerged with a clear verdict: Gibbs is right. The provision does indeed close a tax loophole.

But t the WSJ isn’t entirely completely wrong. The first law of loopholes is that every loophole benefits someone. If you close a loophole, someone will be hurt. That’s what happening here. The extra subsidy for retiree prescription drug coverage provided an extra financial boost for AT&T, Caterpillar, et al. Eliminating the loophole will thus reduce the value of the companies and the wealth of their shareholders, just as the WSJ alleges. But it’s hard to get too teary-eyed since that value and wealth were created by the loophole in the first place.

And now to the details:

Health policy. In 2003, the Medicare Modernization Act added a prescription drug benefit to Medicare. Some employers already provided prescription drug coverage to their retirees, and Congress worried that they would stop these programs and move all those people onto the government nickel. Congress thus created a subsidy to encourage employers to maintain those benefits. The government pays 28% of the cost of qualifying prescription drug coverage for employer-provided prescription drug coverage for retirees who are at least 65. Nothing in the new health legislation would change that.

Tax policy. Congress had to make two decisions in creating this subsidy.

First, would the subsidy be treated as taxable income to recipients? Quite reasonably, Congress answered no.

Second, would for-profit employers still be able to deduct from their taxable income any spending on retiree prescription drug coverage that was covered by the subsidy? For reasons I don’t understand, Congress answered yes. As a result, the AT&Ts of the world could spend $100 on coverage, receive a $28 subsidy, and still deduct $100 in expenses from its income for tax purposes (rather than, say, $72).

In my view, the first decision—subsidies aren’t taxable—makes sense because it treats all employers equally. For-profit firms, non-profit organizations, and state and local governments would all receive the same 28% incentive to maintain retiree coverage. If that subsidy were taxable then either (a) we would have to extend income taxation to non-profits and state and local governments or (b) the subsidy would be smaller for for-profit employers. Neither of those makes sense.

The second decision—for-profit firms can deduct even those expenses that are covered by the subsidy—appears peculiar for the same reason. That provision—which I characterize as a loophole—means that the subsidy is actually more valuable to for-profit firms than to other types of employers. They get the subsidy (without paying taxes on it) and they get the tax benefit of writing off those expenses. As the Joint Committee on Taxation recently noted, that treatment is highly unusual. In my view, it’s right that the recent health legislation closed that loophole.

Financial Accounting. This change doesn’t actually go into effect until 2013. So why all the hullabaloo now? Two words: accrual accounting. Corporations must report the cost of future retiree health benefits as liabilities on their balance sheets. The associated tax subsidies show up as corresponding assets. The value of those tax assets got slashed by the new health legislation. Firms have to report that hit in the quarter in which the law was signed. That’s why we’ve seen this rash of announcements warning shareholders of a surprise hit to first quarter profits. The charges are non-cash at this point—no money is going out the door of these firms just yet—but will turn into real cash (i.e., higher tax payments) in the future.

Note: Another important question is how eliminating the loophole will affect the number of retirees who get drug coverage from their previous employer. Presumably the number will go down, but I haven’t seen any estimates of how much.

Disclosure: I have no investments in AT&T, Caterpillar, Deere, or Verizon

Donald Marron is an economist in the Washington, DC area. He currently speaks, writes, and consults about economic, budget, and financial issues.

From 2002 to early 2009, he served in various senior positions in the White House and Congress including:
* Member of the President’s Council of Economic Advisers (CEA)
* Acting Director of the Congressional Budget Office (CBO)
* Executive Director of Congress’s Joint Economic Committee (JEC)

Before his government service, Donald had a varied career as a professor, consultant, and entrepreneur. In the mid-1990s, he taught economics and finance at the University of Chicago Graduate School of Business. He then spent about a year-and-a-half managing large antitrust cases (e.g., Pepsi vs. Coke) at Charles River Associates in Washington, DC. After that, he took the plunge into the world of new ventures, serving as Chief Financial Officer of a health care software start-up in Austin, TX. After that fascinating experience, he started his career in public service.

Donald received his Ph.D. in Economics from the Massachusetts Institute of Technology and his B.A. in Mathematics a couple miles down the road at Harvard.